Later this week we will find out the results of the third Contracts for Difference (CfD) allocation round. It’s a really big moment for the renewable energy sector, as it means we get to find out which projects have secured support to go ahead. But the CfD auction process is a complicated one, even for those dealing with it on a day-to-day basis. So who can help you if you don’t know your ASP from your elbow? Or your MDD from your LCCC? Fear not! RenewableUK Head of Policy, Rebecca Williams, is here to de-mystify the intricacies of the CfD and get you up to speed.
Why do we need CfD auctions?
The Government’s independent climate advisers, the Committee on Climate Change, are clear that to meet our climate targets we are going to need far more renewables – they want to see the quadrupling of low carbon power by 2050. Fortunately we have just the tool for the job; the Contract for Difference (CfD) mechanism, the UK Government’s flagship scheme for procuring big volumes of clean power at lowest cost to us bill payers. It’s a win for both the climate and our pockets.
Crucially, the CfD provides a framework which gives investors in low carbon energy projects confidence that the UK means business when it is decarbonising. It is the delivery vehicle for the decarbonisation of the power sector, and therefore, by extension, other sectors of our economy.
What is the CfD mechanism?
The CfD is a contract, in private law, between the electricity generator (in this case, a wind farm) and the Low Carbon Contracts Company (LCCC), which is a government-owned company that oversees the administration of the contract. For renewable projects, contracts last for 15 years.
How are CfD contracts awarded?
Developers of clean power projects bid for the CfD contracts in competitive auctions. The Government sets out a pot of money for the auction in advance – this represents the total amount of money available for the auction. For this most recent auction, the budget is £65 million.
When the auction starts, project developers provide two pieces of information: the size of their project, and the strike price for the project - how much they want to be paid per megawatt hour (MWh) of electricity they produce. The Government caps the maximum amount a project can bid for by setting administrative strike prices (ASPs). We’ll come back to these later. Renewable projects bidding into the auction cannot bid over the amount of the ASP. However, project developers can put in a number of different bids based on project size or the price per MWh.
Competition for CfDs is fierce – renewable companies must put in the lowest bid they can to be in with a chance of securing a contract. The auction is administered by National Grid and bids are ranked lowest to highest based on the strike price. The lowest bids are all accepted until the maximum budget has been reached. This year there is also a total capacity cap of 6GW, so a project that wouldn’t breach the budget but would mean the auction delivers over 6GW of capacity would not win a contract.
Projects have to pick a delivery year in which they will start generating power and as this is a “pay as clear” auction, projects delivering in the same year will receive the same strike price – the auction clearing price. The delivery years for this auction are 2023/4 and 2024/5.
Why does the CfD get more renewables built?
The CfD provides investors with certainty over the future of their investments, with a fixed price for each MWh of electricity they generate. Investors face inherent risks in volatile electricity markets. The riskier the project is seen to be, the more it costs overall to secure the financing from banks or investors for the project; the “cost of capital” is higher.
The cost of capital is a defining feature of a renewable project’s costs, and therefore the costs consumers ultimately end up paying. This is because wind is a freely available resource, so when you have built a project there are no fuel costs to keep on paying, just the costs of maintaining your wind farm. However, the biggest proportion of costs that have to be paid by a wind farm are the costs of paying back the money you have borrowed to build it in the first place. Herein lies the beauty of the CfD. The CfD contract “stabilises” a wind farm’s revenues and gives investors the certainty that their money will be paid back in a predictable way over a certain amount of time. This, therefore, reduces the risk associated with the projects, meaning they can secure a lower cost of capital – making the electricity cheaper for consumers.
How does this actually work?
Ok if you’re really keen to geek out, you’ve come to the right place. But this is the bit where you’ll have to bear with me, as it’s when I usually have to start scribbling down diagrams. The CfD contract “stabilises” the revenue of the electricity generator through a relationship between the “strike price” of the contract and the “reference price”. The strike price is the actual price that the generator will be paid per MWh of low carbon power. The reference price is an index of the market price and when this is above the strike price, the generator pays back the difference to the LCCC and, therefore, back to consumers; and when the reference price is lower than the strike price, the generator’s revenue gets topped up.
Who is eligible for a CfD?
The auction currently underway is for less established technologies - offshore wind, tidal stream, wave, biomass with CHP, geothermal and Advanced Conversion Technologies. New for this auction is the inclusion of onshore wind on remote islands.
Notionally all, large-scale renewables in England, Scotland and Wales can compete in CfD auctions providing they meet the eligibility criteria. But since 2015, the government has only run auctions for less established renewables. Established renewables such as onshore wind and solar are currently barred from competing in the CfD as the government has simply not run an auction for these technologies for the last 5 years.
CfD contracts have been awarded – what next?
After the auction results have been announced, projects will decide whether to go forward or not, taking a Final Investment Decision. Successful projects have to take that decision within 12 months year of the auction or demonstrate that they have already spent 10% of the total project cost – that is the Milestone Delivery Date (MDD). From then on, it’s full steam ahead as firms finalise procurement and construction plans to meet their Delivery Year.
What to look out for in this year’s CfD auction:
- Low prices
The last auction in 2017 proved to be a watershed moment for offshore wind, when the cost of the technology plummeted compared to the previous auction in Feb 2015. Prices were, on average, 47% lower than they had been two and half years before.
We are expecting this auction to deliver record amounts of capacity at record low prices. The cost reduction we have seen in offshore is due to a number of reasons – firstly the effects of the CfD in bringing down the cost of capital, and secondly due to impressive technological innovation. Modern offshore turbines are more than 20 times more powerful than those first installed, leading to massive economies of scale. There have also been innovations in components for windfarms including cables, substations and foundations which have cut costs of new capacity.
- Impact of capacity cap
New this year is the introduction of a total capacity cap for the auction. This means that the total volume of low carbon power procured in the auction cannot go above 6GW. It will be interesting to see how this affects the dynamics of the auction and how much people take this into account as part of their bidding strategies.
- Innovative technologies
Cutting edge technologies such as floating offshore wind, remote island onshore wind, wave and tidal can bid in the auction but they have to compete against conventional offshore wind with fixed foundations, which is commercially more advanced than the other technologies. Remember we talked earlier about Administrative Strike Prices – the maximum amount each technology can bid per MWh? For offshore wind these are set at £56/MWh for projects delivering in 2023/24 and £53/MWh in 2024/5. The ASP for remote island onshore wind is £82/MWh in both years, and more than £200/MWh for tidal stream. There prices reflect what the Government estimates each technology would need to be financially viable. But there is no fixed amount of capacity ring-fenced for each technology - they are all competing against each other and the winners will simply be the lowest bidders.
Looking further ahead
The next CfD next auction will be held in 2021, and another in 2023, guaranteeing the development of a future pipeline of projects. It will be fascinating to see what happens to strike prices in the years ahead, as costs are expected to fall even further, which is great news for all of us. The CfD plays a vital role in driving bills down and securing massive amounts of clean power – so it’s well worth getting your head around it.